A promising trinity of reforms

Sri Lanka’s stymied economic reforms agenda gets a major boost. But, will the country be able to make the most of it

Overshadowed by brinkmanship, Sri Lanka’s economy underwent some major reforms, two of which were new laws replacing outdated ones, and the third, an asset disposal. A surrounding mêlée clouded the importance of the legislative changes and the discussion of their long-term economic impact.

The new laws for income and consumption tax administration, and to liberalise foreign exchange transactions together with a billion dollar deal for the long-term lease of the Hambantota sea-port, may not alter the economic trajectory by themselves. However, they are a powerful signal to investors about the government’s resolve to confront its biggest challenges.

How firmly Sri Lanka will grasp the reforms, which have to be backed by regulations and government agencies able to implement those, may determine their success.

Dimantha Mathew, who heads investment bank First Capital’s equity and fixed income research, says these reforms will strengthen the government budget, which has been the main source of Sri Lanka’s instability. In a wide-ranging discussion about the country’s economic outlook, Mathew discussed the long-term outlook for the Sri Lankan economy.

The government has stepped up revenue collection over the last couple of years, and the new Inland Revenue Act will further strengthen that trend

Excerpts from the interview are as follows:

THREE TIMELY REFORMS
The first six months of 2017 was a tough period, we had floods, and on the reforms agenda, there was nothing to talk about after waiting two years for change. We went through a sovereign bond issue, and things started to get better. Three factors led to this. First, the Foreign Exchange Act was passed, followed by the Inland Revenue Act; the Hambantota Port deal was the third factor. Three key things that changed the whole dynamics of the economy, and without which the economy was heading for rough times.

I will start with the debt-to-GDP ratio. We forecast debt to reach 80% of GDP in 2017, up slightly from 79% last year. Now, however, with the three reforms within the last two months, we believe debt-to-GDP will decline going forward to around 77% in 2019. The decline doesn’t seem to be much because our GDP growth is slow. We previously expected the economy to grow 5% this year, but the first six months were bad and GDP grew only 3.9%. We’ve revised down our GDP growth forecast to 4.3% because of the floods. Three months after the floods, the economy still struggles because, unlike last year, nine districts were impacted this time. Consumer demand and buying power went off the system, so there was a crash in retail.

Usually, businesses believe it takes three months to recover from flooding of this magnitude, and for buying power to normalize. So, a part of the third quarter is also slightly affected. GDP growth will not kick-start with the reconstruction efforts and infrastructure development because floods impacted them too—construction had to stop for two to three weeks. The economy will slowly pick up from the third quarter, leading to higher growth in the fourth quarter, which is usually Sri Lanka’s biggest quarter. We could probably have 5% GDP growth. Also, when government revenue improves with the new Inland Revenue Act, the recurrent expenditure gap will be met, so additional borrowings will go into investment and capital expenditure. When that happens, there is more money spent on investments, which will regenerate the economy.

The three reforms will have a big impact going forward. For example, the foreign exchange act is very important for locals. If you take the biggest foreign exchange earners, it’s likely that most of them don’t bring all their foreign earnings into the country. This is because you can’t take it out of the country. If you bring in foreign earnings, it will belong to the government. When you liberalise laws so foreign exchange can be taken out of the country, money will start coming in, like in Singapore. If you want to be an economic hub for the region, you need to liberalise, mainly the outflows.

Right now, people have the right to invest their foreignexchange the wa y they want to, which means there is a high likelihood that more money will start coming in. Worker remittances are an important inflow for Sri Lanka. There’s been a gradual shift towards skilled labour, but remittances are not keeping pace with the amount of labour we export. So you really see the shift. Over the last three years, we’ve seen more skilled labour being exported to Southeast Asia, like Malaysia and South Korea, which has become a big labour export market for Sri Lanka.

Unless the economy takes off, growth may be induced artificially by reducing taxes on imports, consumer electronics and vehicles, as successive governments have done

Sri Lanka is slowly moving towards commercial borrowings, and repayments are due in 2019. We need to get our act together to attract foreign inflows with which to build sufficient reserves. Also, investors feel confident when they know they can freely take their money out, and then they will invest more. That’s why the foreign exchange bill is so important.

TAXING INCOME, NOT TRADE
The government has stepped up revenue collection over the last couple of years, and the new Inland Revenue Act will further strengthen that trend. For the first time, we’re coming closer to achieving the revenue figures estimated in the budget approved by parliament. Over the last 10-15 years, successive governments failed to reach the revenue targets they set out each year in the budget. The new act will bridge the gap between budgeted revenue and actual collection. The new act will also shift the government’s dependence away from indirect taxation to direct taxes.

Export growth is hindered because of high indirect taxes. To grow exports, we need imports. Most indirect taxes like VAT, PAL and NBT are charged on imports; so when government revenue is increased from these sources, it leads to balance of payments problems. The new act will shift the government’s revenue source from imports to collecting taxes from profits. The new act is not looking at asset classes like the previous law, but at sources of income instead, which will be taxed at the appropriate rate.

With that, you’re shifting the focus to direct taxes. In my view, it will be difficult to reduce the dependence on indirect taxes as much as the government would like, unless they start bringing down indirect taxes at the same time. According to the agreement with the IMF, the government has to abolish NBT. This is indicative of the commitment to bring down indirect taxes. If this happens, the poorer segments of the community will benefit, leading to a small buildup of consumer demand. Another precursor to reducing indirect taxes is lowering the telecom levy. I believe this is another tax that can be abolished going forward. The government will abolish five taxes every year going forward. We have 35 different taxes and that needs to be brought down to about 10 or less. This will simplify the tax system and reduce the tax burden as well. This is a regional trend. Even India went through one of its biggest tax reforms recently. So that’s where the region is moving to and we’re in line with the trend.

GROWTH SECTORS
Even though economic growth is slow, the reforms agenda is moving in the right direction, especially with the Inland Revenue Act. As a result, future real incomes will increase with expectations that inflation will be controlled at around 5-6%. We’ve been successful at keeping inflation at these levels over the last five years or so, except for short lapses. So, when you have this sort of conversion from indirect to direct taxation, real income starts moving up. This actually benefits higher-incomegroups, but t he middle income group even more. The middle income group is growing every year, and retail is starting to accelerate.

Sri Lankans’ basic needs are met, especially in urban areas, like electricity and water. The vehicle population has boomed over the last four years, and that’s putting a strain on the transportation system. This is a good problem to have because it’s indicative of the buying power of the growing middle class. With Sri Lanka moving towards upper-middle income status, investors need to make sure they’re investing in asset classes that have high growth potential. For example, demand for branded food and beverages will increase as the middle class continues to grow. People will shift from consuming normal food to the branded or quality food segment. The vehicle segment will continue to grow as well. Earlier, when incomes grew, so did inflation. However, going forward, the new Inland Revenue Act and targeted inflation will result in real income growth. People will enjoy more affordability, but won’t feel it because goods will have the same prices, but incomes  will be higher.

Another growth area is housing; this is why the construction sector is booming. Over the last four years, housing loans have grown from 5% of total lending to 9% by 2017. Listed stocks in the construction sector like Tokyo Cement is seeing demand double. Businesses are adding capacity. Even in retail, Nestlé is investing Rs5 billion over the next five years. Hayleys, a local investor-owned business, acquired the Sri Lankan business of multinational Singer. Locals are beginning to invest. I believe private sector investment will increase as the reforms agenda moves in the right direction. Without reforms, no one will invest.

AVOIDING REPEAT CRISES
There is a risk that reforms could stall in 2019 because of elections and the IMF programme ending around that time as well, which will give the government more leeway to spend.

Unless the economy takes off, growth may be induced artificially by reducing taxes on imports, consumer electronics and vehicles, as successive governments have done. This has led to balance of payments crises every four years since 2008, which means the next crisis is due in 2020, which is also the election year. We expect the government to achieve a revenue surplus in 2017. If the government achieves this and the trend continues, we will have a lower budget deficit in 2019. They won’t have to artificially boost the economy in an election year.

GIVE INVESTORS WHAT THEY WANT
Foreign investors look for stability, and that is what the policy framework must try to achieve.

The government has opted to continue on the hub approach, which no one is opposing. The problems and opposition is around how the government wants to achieve its goals. We need to take some unpopular measures like opening up our borders. The Inland Revenue Act was unpopular, but it was demanded by the IMF. We need to be consistent. The government recently closed one of the largest private equity deals, which is the sale of the Hambantota port. That’s a kick-starter; now that needs to continue. It’s difficult for a dual-party government to reach a consensus, and the decisions they reach need to be binding over a long period. That’s why foreign investment inflows are low, this is obvious especially in the government securities segment.

The government has stepped up revenue collection over the last couple of years, and the new Inland Revenue Act will further strengthen that trend

Foreign inflows of around Rs2-3 million a week trickled into government securities from around February. However, the equities market attracted far more foreign investments. This shows that foreigners want to invest, but are adopting a safe approach by entering the capital markets, so they can exit quickly. They are still not coming in for long-term investments, building factories and recruiting people. The first significant private investment in a while was the Hambantota port deal. I think it will set a trend for what’s to come. Now, expressions of interest have been called for two hotel properties owned by the government. If those deals also happen, it will set the trend for foreigners to come in. And once a big player comes in, it will change things forever, like it did for Malaysia, Vietnam and South Korea. This is why the Hambantota deal is so important.

The Chinese partner will commence operations at Hambantota in November 2017 and invest $700 million on equipment. At the moment, the port has just two cranes, so it can’t generate the required income.

VOLATILE INTEREST RATES
Interest rates have been volatile this year. Government securities yields have declined by 200-350 basis points since March. This is not a good trend from a foreign investor’s perspective. They prefer stability. We’ve had dramatic fluctuations from time to time due to weak government policy. That’s what the Central Bank governor refers to as a sugar high, where the government artificially creates hype in the
economy and that drives interest rates. With better inflation targeting and improving government revenue, we expect to see a more stable interest rate environment. The concern here is the high borrowing requirement to service debt. We’re not settling debts but rolling-over with interest so the borrowing requirement increases every year. Debt payments can only be lowered by transferring out loss-making assets and state-owned enterprises.

Interest rates will rise a slow 100 basis points over the next 12 months across all tenures. Our debt repayment commitment for next year is high. We have $2.3 billion worth of government bonds maturing next year. As if this year wasn’t tough enough with $1.8 billion worth of bonds maturing. We also experienced an outflow of foreign investment earlier in the year. We don’t expect net foreign outflows next year because yields are improving. Our premiums are attractive now compared to regional and peer economies. Frontier and emerging market investors are flowing into the region, but Sri Lanka is not attracting as much as we would like because of the policy-related problems I discussed earlier. Things will certainly improve, but slowly. I don’t expect huge volatility in interest rates. For the whole year, I expect interest rates to have a very slow uptrend, with pressure building towards the second half of 2018. Here on, we are looking at about 100-150 basis points.

A STABLE EXCHANGE RATE
The exchange rate is unlikely to be stable because we’re a net importer. The Central Bank is building reserves by buying US dollars, which depreciates the rupee. This is the right way forward to address the issue of our currency being slightly expensive. The real effective exchange rate is around 106 at the moment and needs to come down to 100 so we can be more competitive. If we’re pursuing a port hub strategy, then this is what needs to happen with the currency.

Unless the economy takes off, growth may be induced artificially by reducing taxes on imports, consumer electronics and vehicles, as successive governments have done

Since we are a net importer, our currency has been depreciating by about 3.5% annually. So roughly, that’s what we should expect on a minimum level. So, if you look at our forecast, we’ve basically slightly upgraded the outlook for this year. We were targeting the exchange rate to be around Rs158-160 to a dollar, and Rs163 next year, which is also in line with the forwards market, which is trading at around a Rs10 premium. Our base-case scenario is Rs163. If the government finds investors for the Colombo port terminal, Mattala Airport and two hotels, and if investor confidence improves, an additional $1-1.5 billion will flow into the system and the exchange rate could be around 160. But, there’s only a 35% chance of that happening because it’s difficult to say if and when these investments would materialise. The Hambantota port agreement took about one and half years to finalise. It’s better not to factor these possibilities. Even in the stock market, there’s a lack of local investor participation. Locals are not confident enough to start investing. Foreign investors are the ones actually buying into the market. At least one thing is clear, the business community is investing in expansion.

DEPOSITS VS. EQUITY
If you are looking at a slightly longer view, I would put more of my money into fixed assets and fixed income instruments. While government securities yields have come down, banks are offering 13.5-14% interests on fixed deposits, which is quite attractive. It’s difficult to assume that people are searching for alternative investment opportunities. In that sense, if the decision is between fixed income and equity, I would have more weight on fixed income assets. Risk-free government securities are good for the short term, so you would have more time if the rates do adjust to the right levels to roll over them at better rates. Bank fixed deposits are the most attractive right now, so that’s where I’d put my money until I’m more clearer on the economic situation.

Beyond that, if the reforms continue, equities will become more attractive. It’s always risk versus reward. Start looking for higher-growth stocks when the picture becomes clearer. A year from now, if the IMF programme is still on, 90% of the reforms would have been completed and the stage set for higher economic growth. So, if you’re a risk taker, equity is still attractive. However, the picture will be clearer only one year later. The Central Bank has already tightened monetary policy to contain consumer demand, so the retail segment is seeing the effects of that now. The floods made matters worse. The economy needs time to recover and stabilise for disposable incomes to grow. It will take time for the government’s unpopular decisions to bear fruit and for real incomes to improve. This is why I’m not getting into equity now. Maybe a year from now, or over the next couple of years, that’s when the economic transformation will show itself.